The Impact of Changing Tax Policies on Family Wealth: A Closer Look

Recent discussions about potential changes in tax policies have generated significant concerns for families seeking to preserve and pass on their wealth. A combination of proposed tax changes—including the elimination of the step-up in basis, higher ordinary and capital gains tax rates, lower estate tax exemptions, and increased estate tax rates—could have a profound impact on the value of a family's assets. This article will explore how these changes could substantially reduce the wealth families have worked hard to accumulate and protect.

1. Elimination of the Step-Up in Basis

The step-up in basis allows heirs to inherit assets at their current market value rather than the original purchase price. Under current law, when someone passes away and leaves assets like stocks, real estate, or a family business to their heirs, the value of those assets is "stepped up" to the fair market value at the time of death. This means the capital gains tax liability on any increase in the asset’s value during the original owner’s lifetime is effectively erased. Heirs only pay taxes on gains that accrue after they inherit the asset.

However, if the step-up in basis is eliminated, heirs would inherit assets with their original purchase price intact, meaning they could be responsible for significant capital gains taxes on decades of appreciation. This change would disproportionately affect families with highly appreciated assets, such as real estate or stocks held for generations.

Example: A family inherits a property originally purchased for $100,000, which is now worth $1 million. Without the step-up in basis, heirs would owe capital gains taxes on the $900,000 gain if they sell the property, potentially resulting in a tax bill of hundreds of thousands of dollars.

2. Higher Ordinary and Capital Gains Tax Rates

In addition to the loss of the step-up in basis, proposed increases in both ordinary and capital gains tax rates could further erode the value of family assets.

• Ordinary Income Taxes: For heirs who inherit assets that generate income (such as rental properties, dividends, or businesses), higher ordinary income tax rates would mean that a larger portion of the income generated by these assets would go to the government. This reduces the overall return on investment, diminishing the value of the inherited wealth over time.
• Capital Gains Taxes: A rise in capital gains tax rates would also mean that any asset sales—whether to diversify a portfolio or generate liquidity—would result in more substantial tax liabilities. Higher taxes reduce the net proceeds from sales, discouraging heirs from selling inherited assets and further complicating wealth preservation strategies.

3. Lower Estate Tax Exemptions

Currently, the federal estate tax exemption is relatively high, at $12.92 million per individual in 2023 (indexed for inflation). However, proposals to lower the estate tax exemption threshold could expose more estates to federal taxation.

If the exemption were to drop significantly—potentially to pre-2017 levels of $5 million or less—many families who were previously exempt from estate taxes would suddenly face hefty tax bills upon the transfer of wealth. This could force heirs to sell off assets to cover estate taxes, particularly in cases where the family’s wealth is tied up in illiquid assets such as real estate or a closely held business.

4. Higher Estate Tax Rates

In addition to a lower exemption threshold, a potential increase in estate tax rates could further erode family wealth. The current top estate tax rate is 40%, but any increase would mean that a larger portion of estates above the exemption level would be subject to taxation.

For wealthy families, the combination of lower exemptions and higher rates would result in a significantly larger portion of their estate being taxed. The impact of estate taxes can be particularly severe when wealth is tied up in long-held assets that may have appreciated substantially over time.

Cumulative Impact on Family Wealth

The combined effects of these proposed changes—elimination of the step-up in basis, higher tax rates, lower exemptions, and increased estate taxes—could substantially reduce the value of family assets over time. Here’s why:

1. Reduced Inherited Wealth: Without the step-up in basis, heirs would face larger capital gains tax liabilities when selling inherited assets. If those assets have appreciated significantly, a large portion of the gain could be lost to taxes, shrinking the wealth that remains in the family.
2. Diminished Returns: Higher ordinary income and capital gains tax rates would reduce the after-tax return on inherited assets, whether they are income-generating properties, businesses, or stock portfolios. This would limit the ability of heirs to grow and preserve their inherited wealth.
3. Liquidity Issues and Forced Sales: Lower estate tax exemptions combined with higher estate tax rates could force heirs to sell assets to pay tax bills. This would be especially problematic if the family’s wealth is concentrated in illiquid assets, such as real estate or a business. Forced sales often result in suboptimal financial outcomes, further reducing the value of the estate.
4. Generational Wealth Transfer Challenges: Families seeking to pass wealth to future generations would face new challenges in minimizing tax liabilities. Traditional estate planning strategies, such as gifting or trusts, may need to be re-evaluated in light of the new tax landscape.

Strategies for Mitigating the Impact

While these potential tax changes are concerning, families can take proactive steps to mitigate their impact:

• Comprehensive Estate Planning: Working with financial advisors and estate planning experts to create a plan that takes into account changing tax laws is essential. Trusts, charitable donations, and lifetime gifting strategies may provide ways to minimize tax exposure.
• Asset Diversification: Spreading wealth across different asset classes can reduce the tax impact on any one asset. For instance, balancing highly appreciated assets with less appreciated ones may help lower the overall capital gains tax burden.
• Reviewing Insurance Policies: Life insurance can be used as a tool to provide liquidity for estate taxes, helping families avoid forced sales of assets.

Conclusion

The proposed elimination of the step-up in basis, combined with higher tax rates and lower estate tax exemptions, has the potential to significantly reduce the value of family assets. Families need to stay informed and take proactive steps to protect their wealth. Effective estate planning will become even more critical in ensuring that families can pass on their wealth to future generations with minimal tax consequences.